Risk is everywhere in life. Whether it is driving to the grocery store, deciding whether to accept a job offer, interacting with strangers, choosing which clothes to wear for the day, or selecting investments, risk will exist in some way shape or form. Some risks can be mitigated and avoided altogether, whereas some risks cannot and simply have to be managed. Most of us aren’t aware of the fact that we deal with risk every day, and in fact manage risk as well through standard processes and habit (i.e. brushing your teeth every day to prevent gum disease and tooth decay). However, when it comes to finance and owning assets, many of us struggle with understanding what risks are in play, and the proper tools of risk mitigation. This article focuses mainly on the tools of managing risk, and less so on risk identification which is required before managing risk, and also less so on risk monitoring which is required after implementing tools to manage risk.
As touched up in Lesson 41, total risk is equal to systematic plus idiosyncratic risk. Risk that can be avoided is called non-systematic, or idiosyncratic, risk. In investing, this can also be referred to as diversifiable risk. A portfolio containing 2 randomly selected stocks from an index will have a larger degree of idiosyncratic risk compared to a portfolio with 25 randomly selected stocks from the same index.
It’s non-systematic because it appears as a supplementary or add on risk to whatever “systematic” risk always exists. Synonymous with market risk, undiversifiable or unavoidable risk, in the context of investing, systematic risk is the risk associated with being invested in the market (i.e. market risk). The same level of market risk will always exist whether you own 2 stocks or 25 stocks in your portfolio. Ultimately, it is the idiosyncratic risk that we look to diversify away from when investing in any asset class or index. Total risk is then equal to the summation of systematic and non-systematic risk.
When looking at systematic and non systematic risk in investing, a graphical representation helps us understand the correlation between diversification and the reduction of total risk within a portfolio. As the number of stocks increases (represented on the x axis), the overall portfolio risk (variance on the y axis), decreases. However, as the number of stocks becomes infinitely large, the amount of risk reduction reduces to zero and a portion of total risk always remains. This is the systematic risk, or market risk in this case, that cannot be diversified away from. Total variance consists of systematic and non systematic risk, and it is the non systematic risk that reduces to 0 as the number of stocks increases.
Figure 1: Systematic and Nonsystematic risk of Investment Portfolio
A more relatable example in real life would look something like this. According to the National Safety Council, there were 42,060 vehicle accident related deaths in 2020 in the United States, and an additional 4.8 million people experiencing injuries due to car accidents. Assuming a population of 328 million people in the US, that would roughly equate to an annual probability of 0.013% of being killed in a vehicle accident, and an annual probability of 1.46% of being injured in one.
This statistical average is your systematic risk. This exists, and you alone have very little impact on the reduction or change of this statistic going forward. When driving, you are cognizant of the fact that there is a very small percent chance that you may end up in an accident and die. That might sound really brash but it’s a risk each one of us accepts when we get behind the wheel of a vehicle. However, there are risks that we can control and mitigate to make us safer on the road, like getting a good sleep the night before or wearing sunglasses or turning off your phone in the car. Not doing any of these three things creates idiosyncratic risk that adds to the overall risk of getting into an accident. But these risks can be avoided and are 100% in your control to mitigate and simply avoid.
Now that we’ve identified the two primary components of overall risk, we need to understand how to manage these risks accordingly. In order to properly mitigate risk, there are three risk prevention and avoidance tools that we can use. These tools will be discussed more specifically to investing and applied to our car accident example, but they can be applied to any sort of risk:
Tools of Risk Prevention and Avoidance
1) Self Insuring
This is the most basic form of risk prevention and avoidance. Self insurance is simply the act of setting aside funds or reserves in order to pay for bills or expenses yourself in the future if something happens that will require you to pay a lump sum of money up front. This is like a rainy day fund, or a “shit happens” fund. In our car example, this would be the same as someone setting aside additional funds for future maintenance or for a future car purchase.
Financial institutions that issue bonds sometimes build up a reserve account as self insurance in order to manage default risk and interest rate risk. This ensures that they will be able to pay back the bondholders in due time, and in the case of callable bonds, take advantage of falling interest rates by buying back the bonds before maturity only to issue them at a lower interest rate (this usually introduces prepayment risk for the bond holders in that the bonds may be called back earlier than what was promised, essentially forgoing any future interest payments).
2) Risk Transfer
This is simply the cost to protect yourself, or insure yourself, against any unexpected event that may arise. This risk management tool effectively shifts the risk to a third party in the event of an adverse outcome or event.
An easy example of this is home or auto insurance. You are paying for protection in the unlikely event that your house is damaged or destroyed, usually due to something outside of your control, or “Act of God” or “Force Majeure” events, as insurance policies often refer to it as. In our car example, purchasing car insurance protects you from the financial risk of getting into an accident and having to come up with money up front to cover third party liabilities, property damage, or your own vehicle damage. The financial risk or liability is transferred to a third party (i.e. the insurance company) so that you do not have to bear the consequences if and when an accident happens. Again, to compensate the third party for taking on this risk, a premium or payment is made to the insurance company.
Insurance is priced in a way where the cost is typically less than the expected benefit over time if something were to happen. Although the likelihood of complete destruction of your home or car is very low, the consequence of that event if it were to occur is astronomical. It is this high consequence that makes it worthwhile to have risk management in place for adverse events affecting your home and vehicle. In finance, risk transfer is usually done through futures contracts, derivatives, or credit default swaps where a “cost” is absorbed to insure or protect the underlying assets under management (buying insurance is really just a credit default swap).
3) Risk Shifting
The third tool is risk shifting, or risk budgeting. This is effectively the act of shifting risk from one area to another, or spreading it out across many areas. Notice how this does not involve reducing risk, but rather “budgeting” it. When building a household budget, you spread your expenses over many categories to understand where you need to budget future savings towards. Very rarely are savings ever designated to only one household expense category, like property tax… what about foundation cracking, new shingles, landscaping, window replacements, etc.? Similarly with risk, especially systematic risk, because eliminating it isn’t possible, we decide to spread it out instead over the operation cycle of whatever activity we are trying to manage risk for.
Although this tool is more common with investing and portfolio management, let’s try to apply it to our car example. We want to drive from Point A to Point B. A simple risk budgeting technique might be to avoid congested traffic areas or to avoid busy freeways where there has been higher than average accident frequency as of late. Perhaps the roads are very snowy today, and instead of driving, you decide to take the bus. The risk of the bus crashing is still there, but the bus is typically being driven at slower speeds, is operated by an experienced certified driver, and undergoes regular maintenance at the depot. At the end of the day, you still get from point A to point B, and the risk of getting into an accident and dying is still there, but you have effectively spread the risk over the activity process of driving from A to B more broadly as opposed to accepting the full systematic risk all at once by yourself in your car via your usual route.
Within an organization, risk budgeting is done to spread risks across internal business units or supply chains to ensure operation at all times and to ensure that risk management objectives are being met. Having one business unit or one facet of a business’ supply chain accept all the risk could be detrimental to a company’s going concern, and the occurrence of an otherwise insignificant event could actually break the operation flow of a business. A perfect example is a company who relies on the use of proprietary technology to remain profitable, but has no cybersecurity in place in its organization. A breach of the company’s IT systems could render the business inoperable since risk was not budgeted appropriately across the organization.
In summary, risk exists in every day life, and to remain effective and operational as a human being or as a business, risks must be identified, managed, and monitored. Although this article mostly focuses on filling your tool belt to manage risk, the identification and monitoring of risks are equally as crucial. Self insurance should be done where it makes sense and the trade off between risk transfer and self insurance is worthwhile. Insurance of pooled risks should be considered if the expected benefit over time outweighs the costs. Risk budgeting involves the balancing and spreading of risk over multiple steps of the activity in which you are managing risk for. Organizations will develop risk management objectives, and balance the cost of risk management against expected benefits to build a risk profile that aligns with these objectives.
Prudent risk management results in improved decision making and a clearer assessment of the risks in place, which also helps maximize value out of the activities we engage in, both personally and with our investing and money management.